FIN 401 Lecture Notes - Lecture 9: Vertical Integration, Risk Management, Deflation

FINANCIAL MANAGEMENT- 14th Edition Chapter #23 - Mini Case

Assume you have just been hired as a financial analyst by Tennessee Sunshine Inc., a mid-sized Tennessee company that specializes in creating exotic sauces from imported fruits and vegetables. The firm’s CEO, Bill Stooksbury, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on the pressing need for companies to institute enterprise risk management programs. Because no one at Tennessee Sunshine is familiar with the basics of enterprise risk management, Stooksbury has asked you to prepare a brief report that the firm’s executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials on derivatives and risk management and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.

a. Why might stockholders be indifferent to whether or not a firm reduces the volatility of its cash flows?

b. What are six reasons risk management might increase the value of a corporation?

c. What is COSO? How does COSO define enterprise risk management?

d. Describe the eight components of the COSO ERM framework.

e. Describe some of the risks events within the following major categories of risk:

o (1) strategy and reputation,

o (2) control and compliance,

o (3) hazards,

o (4) human resources,

o (5) operations,

o (6) technology, and

o (7) financial management.

f. What are some actions that companies can take to minimize or reduce risk exposures?

g. What are forward contracts? How can they be used to manage foreign exchange risk?

h. Describe how commodity futures markets can be used to reduce input price risk.

i. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% before June. You looked online and found that June T-bond futures are trading at 111’25 . What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1% .

j. What is a swap? Suppose two firms have different credit ratings. Firm Hi can borrow fixed at 11% and floating at LIBOR + 1% . Firm Lo can borrow fixed at 11.4% and floating at LIBOR + 1.5% . Describe a floating versus fixed interest rate swap between firms Hi and Lo in which Lo also makes a “side payment” of 45 basis points to Firm L.

6. Institutional portfolios can take advantage of what is called "portfolio margining" under the rules of the CBOE and other options exchanges. What IS portfolio margining? Choose only one answer.

A. You only pay attention to the bottom margin of the portfolio.

B. Great leverage is possible, as the intercorrelations and natural offsets (or what we call in English a "wash") are taken into consideration.

C. No margin is required, because these are not individual investors.

7. What does the symbol ^VVIX mean?

A. Apple's volatility.

B. An exchange-traded (ETF) volatility fund.

C. The implied volatility of the VIX options themselves.

8. An example of purchasing a "real" option is a company's opening of a Shanghai office, in order to have the capacity to pursue business in China.

True

False

9. A hedge fund is "short" a portfolio of VIX call options. It's "theta" is $16,788 per day. This means, barring some big market or political or terrorist event, the fund's net asset value will increase by about $16,788 per day.

True

False

10. Imagine an equity-oriented state pension fund (such as the State of Maryland Pension funds). Suppose their equity portfolio is NOT identical to the S&P 500 index. Further, suppose that due to a state budget shortfall, the year's additions to the pension fund are likely to be less than actuarially sound. Thus, the fund is becoming very risk-averse. And it needs to implement this feeling by hedging. CHOOSE THE BEST ANSWER, even though there might be more than one true answer. This is actually a question about hedge ratios. A. If the equity portfolio's beta is close to 0, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

B. If the equity portfolio's beta is close to .4, then they would have a tough time using S&P 500 contracts, so they would instead use foreign exchange contracts.

C. If the equity portfolio's beta is close to 1, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

11. Go to CMEGROUP.COM We are going to hedge ULSD https://en.wikipedia.org/wiki/Ultra-low-sulfur_diesel for a railroad, that uses ultra-light diesel fuel. Choose June 2017 as the underlying future. Let's pretend we are buying ten futures contracts. What would ten contracts cost you, using the last trade as our price? Show your math, i.e., #gallons times price per futures contract. Is this contract in contango, or normal backwardation?

12. Long options positions(long does not mean long-dated) have positive gamma, and short positions have negative gamma.

True

False

13. In valuing credit default swaps, one must estimate default probabilities. A start would be to obtain historical data for default rates from rating agencies such as Standard & Poor's. But a more complete risk profile, or risk prediction, limiting ourselves to the US market (US-based companies) would be to [pick only one choice, the best one, in your opinion]:

A. Also consider the risk of another earthquake in Japan.

B. Also consider the systematic risk associated with an economic downturn in the US, accompanied by a downturn in US stocks.

C. Also consider the possibility that Facebook options are trading at an implied volatility that is not as high as it should be, considering the lofty level of its P/E ratio.

14. A total return swap can be a form of financing vehicle to allow an investor to buy a specific bond, because: (there are two correct answers, you must pick two)

A. The payer (a financial institution) could agree to pay the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

B. The payer (a financial institution) could agree to receive the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

C. The payer retains ownership of the bond for the life of the contract.

Derivative

Vanguard High Yield Corporate Fund
Materials
• Website information (23/05/2016)
https://personal.vanguard.com/us/funds/snapshot?FundId=0029&FundIntExt=INT
• Summary Prospectus (27/05/2015)
• Prospectus (27/05/2015)
Anakin’s Job
In May 2016, Anakin leaves his job in Hollywood and returned to the finance industry. It is his
first love after all and the industry appears to be picking up again after the credit crunch of
2007-2008. He applies to be the risk analyst to the fund manager of the Vanguard High Yield
Corporate Fund as his quantitative training positions him well for a job that requires ever more
numerical and computational skills over the years. His solid background in applied analytics
in business management and humble demeanour help him clinch the post without much
difficulty.
The Vanguard Group is an American investment company that has approximately USD 3
trillion in asset-under-management. It is founded in 1975 by John Bogle who created the first
index fund (tied to the S&P 500 index) in the process. After an initial lull, the index grew
rapidly along with the bull market of the 1980s. The Group has since added various financial
services and products to its core business, particularly the ETFs.
Anakin is tasked by the fund manager to become thoroughly familiar with the structure of the
fund as is documented by files provided under “Materials”. After that, he is to assess the
exposure of the High Yield Corporate Fund to risks in the market. He seeks the opinion of
Darth who is a veteran market analyst with the Vanguard Guard group for over 20 years.
Outlook
Darth has this to say about the economy and fixed income market:
" The US economy is improving steadily. It will not be long before the Fed decides to raise
interest rates. Once the Fed restarts the regime of rising rates, it will about 2 years for the yield
curve to rise by 100 basis points.
Consequently, in the more stringent economic environment, companies of lower credit
qualities, namely those of Caa and below, are expected to have their credit standing further
eroded. There is a 25% chance that a Caa-rated issuer may go into default and another 25%
chance that it may be downgraded to C.
The Greek debt problem, though much stabilized than before, is still a matter of grave concern
for the Eurozone. Expect the euro to depreciate against the dollar over the course of the next 6
months. A fall of 500 pips will not be a surprise. "
Assume Anakins’ role and answer the following questions. Questions 1 and 2 concern the
Financial Environment. The Environment at large provides the context and sets the constraints
within which financial decisions are weighed and taken. Questions 3 and 4 pertain to the task
that Anakin needs to complete.

Question 4
The fund is affected by changes in the financial markets. When interest rates rise, the value of
the portfolio falls. Occurrences that are flagged by the rating agency to be credit events can
result in the downgrading of credit rating of bond issuers. Bonds that denominated in foreign
currency are affected by fluctuations in the foreign exchange market.
(a) Analyse generally the need for hedging the various market risks for the fund.

Take into account Darth’s outlook. Address some of these risk concerns by answering the
following question:
(b) Suppose that in the coming 2 years, the prevailing interest rates are expected to go up
by 100 basis points and you are concerned. Show how you could hedge away the
interest rate risk by using an interest rate swap, assuming that the fund by may
represented by a single 5-year par bond on the $18.4 billion net assets with semi-annual
5% coupon payments starting from the current date.
In your explanation, you may assume a scenario in which a flat yield curve increases
uniformly across all terms by 25 basis points per half-a-year.
(c) Credit default swaps may be used to ameliorate credit risk. Appraise the use of such
option-like derivative instruments in managing the risk of the portfolio by explaining
how such instruments function.

https://institutional.vanguard.com/VGApp/iip/site/institutional/investments/productoverview?fundId=0029